Engineering Earnings

This week's economic data continued to depict an economy gaining strength. However,
the stock market has not been impressed as the S&P 500 closed at a two-month
low on Tuesday. The bond market has been where the action is and it is amazing
how contained the stock market has been given the historic increase in long-term
interest rates. Corporate earnings have been in the spotlight for the past
month. While corporate earnings managed to beat analyst's estimates, results
were not as high quality as was priced into the market. Investors realized
that second quarter earnings growth was more a function of cost cutting and
favorable currency gains than quality earnings growth.

Monday's release of the ISM non-manufacturing survey revealed that the service
sector continued to expand. The survey of service sector business activity
jumped 4.5 points to 65.1; this was the highest level since the index was created
in July 1997. Strength was led by new orders, which soared 9.4 points to 66.9,
which was also a record. Employment registered the second consecutive month
over 50 since the first two months of 2001 when the component was trending
down. Economic strength has started seeping into the manufacturing sector.
Last week, the manufacturing ISM showed expansion in July for the first time
since February. New orders jumped 4.4 points to 56.6, a level not seen since
January.

Vehicle sales in July jumped 5% from June to a 17.3 million annual rate. Not
only was this higher than economists expected, but the highest rate of the
year. The Big Three lost 2.2% market share in July from last year. Every month
this year, the Big Three have lost market share on a year-over-year basis.
Market share has continued to fall even as the Big Three have piled on the
incentives. General Motors still offers the largest average incentive, $3,994,
but Ford and Chrysler are catching up. Ford's average incentive jumped 7.4%
in the last month to $3,986 and Chrysler's soared 12% to $3,958. Even the Japanese
automakers have increased their incentives, but still remain substantially
below the US manufacturers. Toyota's average incentive increased 15% to $1,132,
while Honda's jumped 44% to $805. Nissan only increased its incentive by 6%
to $1,492.

Most retailers will report July sales on Thursday, but a few have already
reported. While it is an extremely limited sample, so far it appears retail
activity in July mirrored auto sales, which indicates the consumer has yet
to slow down. Even sales at Costco, which has seen its stock decline over 20%
this week, said July same store sales increased 8.0%. Bank of Tokyo-Mitsubishi
estimates that July same store sales will be 3% ahead of last July.

With earnings season nearing completion, Ryan wanted to analyze how the weaker
dollar helped revenue growth. He also dug into the quality of Cisco's earnings,
so without further ado:

We started with the 30 Dow Jones Industrials and looked for the effect of
currency gains on top-line growth. Out of the 30 Dow companies only eleven
separated revenue growth and currency-adjusted revenue growth. Understandably,
this is not a statistically significant sample, but it still proves useful
in witnessing how a weak dollar benefits the multinational companies. The results
are difficult to ignore. A remarkable 4.8% of the 7.6% (63%) average revenue
growth of the eleven companies that reported revenue growth was due to currency
gains. Joe Basset of Banc One Investment Advisors summed up the current business
climate, "A lot of the top-line growth is still anemic, especially if
you consider foreign exchange."

"What components were the biggest beneficiaries of the dollar decline?" one
might reasonably ask. IBM achieved 70% of its 10% revenue growth due to currency
gains from a weaker dollar. Eastman Kodak would have shown second quarter revenue
growth of negative 5% instead of the 1% it did show had currency not been an
issue. And of the double digit revenue increase (10%) from McDonald's in the
most recent quarter, a full 60% of that was due to foreign currency gains.

Dow Jones: Currency Impact on Q2 Revenue

Component Name

Q2 Revenue with Currency Gain

Q2 Revenue without Currency Gain

Difference

3M

11.0%

5.4%

5.6%

Altria

-1.3%

-5.7%

4.4%

American Express

6.9%

4.9%

2.0%

Caterpillar

12.1%

7.9%

4.2%

Du Pont

10.0%

5.0%

5.0%

Eastman Kodak

0.5%

-5.5%

6.0%

Honeywell

2.0%

-2.0%

4.0%

IBM

10.0%

3.0%

7.0%

Johnson & Johnson

13.9%

8.9%

5.0%

McDonald's

10.0%

4.0%

6.0%

Procter & Gamble

8.0%

4.0%

4.0%

AVERAGE

7.6%

2.7%

4.8%

Since many firms hedge their foreign exchange exposure and the accounting
data does not require division by division results in home currencies, it is
difficult to analyze how currency translation affects the bottom line. Revenue
data is all that we have to analyze, at least until 10-Qs and 10-Ks are filed.
The results show that companies benefited from outside forces during the second
quarter. In order for investors to maintain comfort with second half earnings
estimates, companies will have to do a better job at growing revenues.

Last night after the market close, networking solutions provider Cisco Systems
released their fourth quarter and fiscal year 2003 financial results. Investors
were duly unimpressed, as the stock has declined 6% since yesterday's close.
Cisco reported that it had no fiscal year revenue growth and fourth quarter
revenue fell by 2.6%. Note these growth numbers are inclusive of currency gains
and the incremental revenue from the Linksys acquisition. Revenue guidance
for the tech bellweather was equally benign, as CEO John Chambers said that
revenues are expected to increase roughly 2% in the first quarter of fiscal
2004.

Cisco's fourth quarter income statement was filled with examples of one-time
tricks that are often only lesson in text books. There were several line items
that helped boost net income during the fourth quarter that cannot be relied
upon for continued growth. Differences in amortization of purchased intangible
assets accounted for $178 million of the increase, a decline in research and
development accounted for $27 million. Furthermore, allowance for doubtful
accounts declined substantially (45%) from $335 million in Q4 2002 to $183
million in Q4 2003 despite accounts receivables jumped by $246 million. Adding
all these factors together Cisco's pre-tax income actually declined by 11.1%
instead of the 25.2% growth Cisco reported. Furthermore, the repurchase of
shares added a cent to Cisco's net income per share.

Cisco Systems

Q4 2003 and 2002 Comparisons in $ millions

Q4 2003

Income before tax

$ 1,373

less: difference in amortization of

purchased intangible assets

$ (178)

less: difference in process

research and development

$ (27)

less: difference in interest income

$ 62

less: difference in other income

$ (81)

less: difference in allowance

for doubtful accounts

$ (174)

Revised Income before tax

$ 975

Change over Q4 2002

-11.1%

Cisco currently trades at 30 times trailing earnings. This is a company that
had declining quarterly year-over-year revenue and used earnings management
to achieve Wall Street estimates.